chapter 2

SUPPORT BUSINESS STRATEGY

A currently popular theory found in almost every business book and consultant's report tells managers to tailor their pay systems to align with the organization's business strategy. The rationale is based on contingency notions. That is, differences in a firm's business strategy should be supported by corresponding differences in its human resource strategy, including compensation. The underlying premise is that the greater the alignment, or fit, between the organization and the compensation system, the more effective the organization. Exhibit 2.3 gives an example of how compensation systems might be tailored to three general business strategies. The innovator stresses new products and short response time to market trends. A supporting compensation approach places less emphasis on evaluating skills and jobs and more emphasis on incentives designed to encourage innovations. The cost cutter's efficiency-focused strategy stresses doing more with less by minimizing costs, encouraging productivity increases, and specifying in greater detail exactly how jobs should be performed. The customer-focused business strategy stresses delighting customers and bases employee pay on how well they do this. Other business strategy frameworks rely on similar ideas. In Michael Porter's strategy work, firms that cut costs would be said to follow a cost leadership strategy, whereas those that seek to provide a unique and/or innovative product or service at a premium price are said to follow a differentiation strategy. Likewise, Miles and Snow refer to defenders as those that operate in stable markets and compete on cost, whereas prospectors are more focused on innovation, new markets, and so forth. These are known as generic strategy frameworks. Conventional wisdom would be that competing on cost requires lower compensation, whereas competing through innovation is likely to be more successful with high-powered incentives/pay for performance. Most firms, however, do not have generic strategies. Instead, as our discussion below suggests, they tend to have aspects of cost and innovation. Likewise, compensation strategies do not necessarily line up neatly with generic business strategies. Although Lincoln Electric, Nucor Steel, and Southwest Airlines rely heavily on cost leadership in their strategies, they pay their employees well above market (e.g., using stock and profit sharing plans) when (and, importantly, only when) firm performance is strong. SAS follows a customer and innovation strategy, but uses little in the way of pay for performance. If you think about it, if a particular business strategy automatically meant that a particular pay strategy would work best, there would not be much need for managers. These generic business strategy and pay strategy ideas are a good starting point. But to do better than its competitors, a firm must consider how to fashion its own unique way of adding value through matching its business strategy and pay strategy. How do Google, Nucor, and Merrill Lynch fit into these generic business strategies? Look again at Exhibit 2.3. At first pass, Google might be an innovator and Merrill Lynch customer focused. Nucor is an innovator in its capability to recycle scrap steel while also being a dedicated cost cutter and productivity-focused. Yet managers in these companies would probably say that their company is a combination of all three descriptors. Merrill Lynch is also an innovator in financial investment derivatives and seeks to control costs. So like our discussion of yin and yang in Chapter 1, the reality for each company is a unique blending of all three strategies. It also follows that when business strategies change, pay systems should change, too. A classic example is IBM's strategic and cultural transformation. For years IBM placed a strong emphasis on internal alignment. Its well-developed job evaluation plan, clear hierarchy for decision making, work/life balance benefits, and policy of no layoffs served well when the company dominated the market for high-profit mainframe computers. But it did not provide flexibility to adapt to competitive changes in the new century. A redesigned IBM no longer sells the PCs they popularized. Instead, IBM describes its current strategy as having a "focus on the high-growth, high-value segments of the IT industry." It notes, for example, that it "has exited commoditizing businesses like personal computers and hard disk drives." IBM describes its current global capabilities as including "services, software, hardware, fundamental research and financing," and reports that this "broad mix of businesses and capabilities are combined to provide business insight and solutions for the company's clients." Exhibit 2.4 depicts IBM's "New Blue" approach to executing its strategy. A new Page 48business strategy meant a new compensation strategy. At IBM this meant streamlining the organization by cutting layers of management, redesigning jobs to build in more flexibility, increasing incentive pay to more strongly differentiate on performance, and keeping a constant eye on costs. IBM changed its pay strategy and system to support its changed business strategy. The jury is still out on whether it will work, as IBM's stock price is down substantially over the last five years, in contrast to a substantial increase of 66 percent of the Dow Jones Index over that same period.

THE PAY MODEL GUIDES STRATEGIC PAY DECISIONS

Let us continue our discussion of Whole Foods. The competitive advantage of Whole Foods is apparent with the first visit to one of its grocery stores, described as "a mouth-watering festival of colors, smells, and textures; an homage to the appetite." What started out in 1978 as a small health food store in Austin, Texas, has, through strategic decisions, grown to become the world's leading natural and organic foods supermarket, whose objective is to change the way Americans eat. Along the way, Whole Foods' managers have designed a total compensation system to support the company's phenomenal growth (from 10,000 "team members" and $900 million in sales in 1996 to 87,000 "team members" and sales of $16 billion today) while remaining true to company founder John Mackey's vision for the company. Whole Foods has been on the Fortune list of Best Companies to Work For 20 consecutive years. (Whole Foods was acquired in 2017 for $13.7 billion by Amazon, and it remains to be seen whether its compensation and human resource strategies will remain the same. However, John Mackey has so far continued as CEO, which would suggest planned continuity.) Using our pay model, let us consider the five strategic compensation choices facing Whole Foods managers. - Objectives: How should compensation support the business strategy and be adaptive to the cultural and regulatory pressures in a global environment? (Whole Foods objectives: Increase shareholder value through profits and growth; go to extraordinary lengths to satisfy and delight customers; seek and engage employees who are going to help the company make money—every new hire must win a two-thirds vote from team members before being given a permanent position.) - Internal Alignment: How differently should the different types and levels of skills and work be paid within the organization? (Whole Foods: Store operations are organized around eight to ten self-managed teams; these teams make the types of decisions [e.g., what products to order and stock] that are often reserved for managers. Egalitarian, shared-fate philosophy means that executive salaries do not exceed 19 times the average pay of full-time employees [the ratio used to be 8 times; note that for top executives, salary typically accounts for well under one-half of total compensation]; all full-time employees qualify for stock options, and 94 percent of the company's options go to nonexecutive employees.) - External Competitiveness: How should total compensation be positioned against competitors? (Whole Foods: Offer a unique deal compared to competitors.) What forms of compensation should be used? (Whole Foods: Provide health insurance for all employees working at least 20 hours/week and 20 hours of paid time a year to do volunteer work.) - Employee Contributions: Should pay increases be based on individual and/or team performance, on experience and/or continuous learning, on improved skills, on changes in cost of living, on personal needs (housing, transportation, health services), and/or on each business unit's performance? (Whole Foods: A shared fate—every four weeks the performance of each team is measured in terms of revenue per hour worked, which directly affects what they get paid. [This is one reason staffers are given some say in who gets hired—co-workers want someone who will help them make money!]) - Management: How open and transparent should the pay decisions be to all employees? Who should be involved in designing and managing the system? (Whole Foods: "No-secrets" management: Every store has a book listing the previous year's pay for every employee, including executives; "You Decide"—employees recently voted to pick their health insurance rather than having one imposed by leadership.) These decisions, taken together, form a pattern that becomes an organization's compensation strategy.

VIRTUOUS AND VICIOUS CIRCLES

A group of studies suggests specific conditions to look at when making strategic pay decisions. One study examined eight years of data from 180 U.S. companies. The authors reported that while pay levels (external competitiveness) differed among these companies, they were not related to the companies' subsequent financial performance. However, when combined with differences in the size of bonuses and the number of people eligible for stock options, then pay levels were related to future financial success of the organizations. This study concluded that it is not only how much you pay but also how you pay that matters. Think of pay as part of a circle. Exhibit 2.9 suggests that performance-based pay works best when there is success to share. An organization whose profits or market share is increasing is able to pay larger bonuses and stock awards. And paying these bonuses fairly improves employee attitudes and work behaviors, which in turn improves their performance. The circle gains upward momentum. Employees receive returns that compensate for the risks they take. And they behave like owners, since they are sharing in the organization's success. Additionally, there are several studies that analyzed pay strategies as part of the "high-performance workplace" approaches discussed earlier. This research focused on specific jobs and workplaces, such as sales and service representatives in call-service centers and jobs in factories. They indicate that performance-based pay that shares success with employees does improve employee attitudes, behaviors, performance—especially when coupled with the other "high-performance" practices. One study even reported that the effects of the compensation strategy equaled the impact of all the other practices [high involvement, teams, selective hiring, and training programs] combined. These findings are near and dear to our hearts. So other "high-performance" HR practices also become factors that support improved performance and the virtuous circle. It cannot have escaped your attention that circles can also gain momentum going downward to become a vicious circle. As shown in Exhibit 2.9, when organization performance declines, performance-based pay plans do not pay off; there are no bonuses, and the value of stock declines—with potentially negative effects on organization performance. Declining organization performance increases the risks facing employees—risks of still smaller bonuses, demotions, wage cuts, and even layoffs. Unless the increased risks are offset by larger returns, the risk-return imbalance will reinforce declining employee attitudes and speed the downward spiral. Unfortunately, we do not yet know what compensation practices can be used to shift an organization caught in a downward spiral into an upward one. Perhaps we believe so strongly that pay matters and that studying it in the workplace is beneficial, that this is what we see—believing is seeing. So, caution and more evidence are required. Nevertheless, these studies do seem to indicate that performance-based pay may be a best practice, under the right circumstances. (Could performance-based pay sometimes be a "worst practice"? Yes, when incentive systems don't pay off and they alienate employees or lead to government investigation of possible stock option manipulation.) Additionally, we do not have much information about how people perceive various pay strategies. Do all managers "see" the total compensation strategy at Merrill Lynch or Google the same way? Some evidence suggests that if you ask 10 managers about their company's HR strategy, you get 10 different answers. If the link between the strategy and people's perceptions is not clear, then maybe we are using evidence to build on unstable ground.

Align

Alignment of the pay strategy includes three aspects, as we have already discussed: (1) align with the business strategy, (2) align externally with the economic and sociopolitical conditions, and (3) align internally within the overall HR system. Alignment is probably the easiest test to pass.

STRATEGIC CHOICES

Strategy refers to the fundamental directions that an organization chooses. An organization defines its strategy through the trade-offs it makes in choosing what (and what not) to do. Exhibit 2.2 ties these strategic choices to the quest for competitive advantage. At the corporate level, the fundamental strategic choice is: What business should we be in? At the business unit level, the choice shifts to: How do we gain and sustain competitive advantage in this business? At the function level the strategic choice is: How should total compensation help this business gain and sustain competitive advantage? The ultimate purpose—the "So What?"—is to gain and sustain competitive advantage. A strategic perspective focuses on those compensation choices that help the organization gain and sustain competitive advantage.

Step 2: Map a Total Compensation Strategy

The compensation strategy is made up of the elements in the pay model: objectives, and the four policy choices of alignment, competitiveness, contributions, and management. Mapping these decisions is Step 2 in developing a compensation strategy. Mapping is often used in marketing to clarify and communicate a product's identity. A strategic map offers a picture of a company's compensation strategy. It can also clarify the message that the company is trying to deliver with its compensation system. Exhibit 2.8 maps the compensation strategies of Microsoft and SAS. The five dimensions are subdivided into a number of descriptors rated on importance. These ratings are from your fearless (read "tenured") authors. They are not ratings assigned by managers in the companies. The descriptors used under each of the strategy dimensions can be modified as a company sees fit. Objectives: Prominence is the measure of how important total compensation is in the overall HR strategy. Is it a catalyst, playing a lead role? Or is it less important, playing a more supporting character to other HR programs? At Microsoft, compensation is rated highly prominent, whereas at SAS it is more supportive. Internal Alignment: This is described as the degree of internal hierarchy. For example, how much does pay differ among job levels and how well does compensation support career growth? Both SAS and Microsoft use pay to support flexible work design and promotions. But pay differences at SAS, whose philosophy is "Everyone is part of the SAS family," are smaller than at Microsoft, where differences in pay are seen as returns for superior performance. External Competitiveness: This includes comparisons on two issues. How much are our competitors paying, and what forms of pay are they using? The importance of work/life balance achieved via benefits and services is also part of external competitiveness. According to the strategy map, Microsoft's competitive position is critical to its pay strategy, whereas SAS competes on work/family balance in family-oriented benefits such as private schools and doctors on the company's campus. Employee Contributions: These two companies take a very different approach to performance-based pay. SAS uses only limited individual-based performance pay. This is consistent with its overall egalitarian approach. Microsoft makes greater use of pay based on individual and company performance. Management: Ownership refers to the role non-HR managers play in making pay decisions. Transparency refers to openness and communication about pay. As one might expect, both Microsoft and SAS rate high on the use of technology to manage the pay system, and Microsoft offers greater choices in their health care and retirement investment plans. Each company's profile on the strategy map reflects its main message or "pay brand": - Microsoft: Total compensation is prominent, with a strong emphasis on market competitiveness, individual accomplishments, and performance-based returns. - SAS: Total compensation supports its work/life balance. Competitive market position, company-wide success sharing, and egalitarianism are the hallmarks. In contrast to the verbal description earlier in this chapter, strategic maps provide a visual reference. They are useful in analyzing a compensation strategy that can be more clearly understood by employees and managers. Maps do not tell which strategy is "best." Rather, they provide a framework and guidance. Just like a road map, they can show where you are and where you are going. The rest of this book discusses compensation decisions in detail. It is important to realize, however, that the decisions in the pay model work in concert. It is the totality of these decisions that forms the compensation strategy.

Stated versus Unstated Strategies

All organizations that pay people have a compensation strategy. Some may have written compensation strategies for all to see and understand. Others may not even realize they have a compensation strategy. Ask a manager at one of these latter organizations about its compensation strategy and you may get a pragmatic response: "We do whatever it takes." Its compensation strategy is inferred from the pay decisions it has made. Managers in all organizations make the five strategic decisions discussed earlier. Some do it in a rational, deliberate way, while others do it more chaotically—as ad hoc responses to pressures from the economic, sociopolitical, and regulatory context in which the organization operates. But in any organization that pays people, there is a compensation strategy at work.

SUPPORT HR STRATEGY

Although a compensation strategy that supports the business strategy implies alignment between compensation and overall HR strategies, this topic is important enough that we want to explicitly deal with it. In the literature on so-called high-performance work systems (HPWS) and HR strategy, Boxall and Purcell describe a "very basic theory of performance", which they refer to as "AMO theory": P = f(A,M,O) P is performance, which is specified to be a function (f) of three factors: A is ability, M is motivation, and O is opportunity.23 In other words, the AMO logic is that HR systems will be most effective when employee ability is developed through selective hiring and training and development, when the compensation system motivates employees to act on their abilities, and when roles are designed to allow employees to be involved in decisions and have an impact. (It is also common to refer to the O part as E, for environment.) Compensation (through incentive and sorting effects) is the key to attracting, retaining, and motivating employees with the abilities necessary to execute the business strategy and handle greater decision-making responsibilities. Compensation is also the key to motivating them to fully utilize those abilities. As such, higher pay levels and pay for performance are often part of such an HPWS. Consider alignment between compensation and other aspects of HR at SAS. Rather than being sold in a one-time transaction, SAS's software is licensed. This is part of a business strategy by which SAS gets ongoing and substantial feedback from customers regarding how products can be continually improved and also regarding what new products customers would like. To support this long-term customer relationship, SAS seeks to have low employee turnover. Its heavy emphasis on benefits in compensation seems to be helpful in retaining employees. SAS also gets many job applications, which allows it to be very selective in its hiring. That no doubt helps build a highly able workforce and allows selection of those who fit SAS's emphasis on teamwork and idea sharing. The deemphasis on pay for individual performance probably reduces the risk that competition among employees will undermine this objective. As we discuss in the next section, Whole Foods also is team-based. Unlike SAS, however, it relies heavily on pay for performance. But it is team performance that matters. (Contrast the deemphasis on differences in individual performance at SAS and Whole Foods with the very different approach—strong emphasis on individual pay for performance—that seems to fit the business and HR strategies of companies such as General Electric, Nucor Steel, Lincoln Electric, and Merrill Lynch.) How effective can a compensation strategy be in supporting business strategy if it is at cross-purposes with the overall HR strategy? While reading about Whole Foods below, ask yourself how well its reliance on teams and giving workers wide decision latitude would work with a different compensation strategy. Such a mismatch happens surprisingly often. Compensation strategy and HR strategy are central to successful business strategy execution. Exhibit 2.5 seeks to capture that idea, the importance of AMO and fit. It also makes the very simple, but very important, observation that all of this comes down to effects on either revenues or costs. Compensation strategy, HR strategy, and business strategy ultimately seek to decrease costs or increase revenues, relative to competitors. At the same time, key stakeholders (e.g., employees, customers, shareholders) must be happy with their "deal" or relationship with the company. To the extent all of this happens, effectiveness is more likely to follow.

"BEST PRACTICES" VERSUS "BEST FIT"?

The premise of any strategic perspective is that if managers align pay decisions with the organization's strategy and values, are responsive to employees and union relations, and are globally competitive, then the organization is more likely to achieve competitive advantage. The challenge is to design the "fit" with the environment, business strategy, and pay plan. The better the fit, the greater the competitive advantage. But not everyone agrees. In contrast to the notion of strategic fit, some believe that (1) a set of best-pay practices exists and (2) these practices can be applied universally across situations. Rather than having a better fit between business strategy and compensation plans that yields better performance, they say that best practices result in better performance with almost any business strategy. These writers believe that adopting best-pay practices allows the employer to gain preferential access to superior employees. These superior employees will in turn be the organization's source of competitive advantage. The challenge here is to select from various recommended lists which are "the" best practices. Which practices truly are the best? We believe that research over the past few years is beginning to point the way to improve our choices.

HR Strategy: Pay as a Supporting Player or a Catalyst for Change?

As noted earlier, the pay strategy is also influenced by how it fits with other HR systems in the organization. Whatever the overall HR strategy, a decision about the prominence of pay in that HR strategy is required. Pay can be a supporting player, as in the high-performance approach, or it can take the lead and be a catalyst for change. Whatever the role, compensation is embedded in the total HR approach. So, the compensation implications of all the above factors—the organization's business strategy, global competitive dynamics, culture and values, the sociopolitical context, employee preferences, and how pay fits with other HR systems—all are necessary to formulate a compensation strategy. Culture/Values - A pay system reflects the values that guide an employer's behavior and underlie its treatment of employees. The pay system mirrors the company's image and reputation. As we noted in Chapter 1, most companies publish a values statement on their websites. Medtronic publishes theirs in 24 languages. Part of it is in Exhibit 2.7. Medtronic's value #5 recognizes employees' worth by fostering "personal satisfaction in work accomplished, security, advancement opportunity, and means to share in the company's success." Its compensation strategy reflects this value by including work/life balance programs for security, incentives, and stock ownership to share the company's success. But there are some skeptics out there. Mission statements have been described as "an assemblage of trite phrases" that impress no one. In contrast, Johnson and Johnson considers its statement its "moral compass" and "recipe for business success." Social and Political Context - Context refers to a wide range of factors, including legal and regulatory requirements, cultural differences, changing workforce demographics, expectations, and the like. These also affect compensation choices. In the case of Whole Foods, its business is very people-intensive. Consequently, Whole Foods managers may find that an increasingly diverse workforce and increasingly diverse forms of pay (child care, chemical dependency counseling, educational reimbursements, employee assistance programs) may add value and be difficult for competitors (other supermarkets) to imitate. Because governments are major stakeholders in determining compensation, lobbying to influence laws and regulations can also be part of a compensation strategy. In the United States, employers will not sit by while Congress considers taxing employee benefits. Similarly, the European Union's "social contract" is a matter of interest. And in China, every foreign company has undoubtedly discovered that building relationships with government officials is essential. So, from a strategic perspective, managers of compensation may try to shape the sociopolitical environment as well as be shaped by it. Employee Preferences - The simple fact that employees differ is too easily overlooked in formulating a compensation strategy. Individual employees join the organization, make investment decisions, interact with customers, design new products, assemble components, and so on. Individual employees receive the pay. A major challenge in the design of next-generation pay systems is how to better satisfy individual needs and preferences. Offering more choice is one approach. Older, highly paid workers may wish to defer taxes by putting their pay into retirement funds, while younger employees may have high cash needs to buy a house, support a family, or finance an education. Dual-career couples who have double family coverage may prefer to use more of their combined pay for child care, automobile insurance, financial counseling, or other benefits such as flexible schedules. Employees who have young children or dependent parents may desire dependent care coverage. Whole Foods, in fact, as described in its annual report each year, holds an employee vote every three years to determine the nature of their benefits program. As an example of employee preference data that can be collected, based on the opinions of 10,000 U.S. workers, Hudson found that: (Nearly three out of four U.S. workers claim to be satisfied with their compensation, yet a large portion of the same sample (44 percent) say they would change their mix of cash and benefits if given the chance.), (When given their choice of unconventional benefits, most employees would select a more flexible work schedule (33 percent) or additional family benefits (22 percent), including parental leaves and personal days, over job training (13 percent) or supplemental insurance (16 percent).), and (One in five workers say better health care benefits would make them happier with their compensation package. On the other hand, 41 percent said that the single thing that would make them happier is more money.) Choice Is Good. Yes, No, Maybe? - Contemporary pay systems in the United States do offer some choices. Flexible benefits and choices among health care plans and investment funds for retirement are examples. As noted above, Whole Foods employees vote on the benefits they want. Netflix employees can choose the mix of stock options and salary. General Mills similarly allows many employees to swap several weeks' salary for stock awards. The company believes that allowing employees their choice adds value and is difficult for other companies to imitate—it is a source of competitive advantage for General Mills. Whether or not this belief is correct remains to be studied. Some studies have found that people do not always choose well. They do not always understand the alternatives, and too many choices simply confuse them. Thus, the value added by offering choices and satisfying preferences may be offset by the expense of communicating and simply confusing people. In addition to possibly confusing employees, unlimited choice would be a challenge to design and manage. Plus, it would meet with disapproval from the U.S. Internal Revenue Service (health benefits are not viewed by the IRS as income). Offering greater choice to employees in different nations would require meeting a bewildering maze of codes and regulations. On the other hand, the U.S. federal government, including the IRS, already offers its employees a bit of choice in their work schedules. Forty-three percent avail themselves of the option to take compensatory time off for extra hours worked. In contrast, U.S. private sector workers covered by the Fair Labor Standards Act (i.e., nonexempt employees) must be paid time-and-a-half overtime if they work over 40 hours in a week. A compensatory time option is not permitted. Union Preferences - Pay strategies need to take into account the nature of the union-management relationship. Even though less than 7 percent of U.S. private-sector workers are now in labor unions, union influence on pay decisions remains significant in key sectors (e.g., manufacturing, health care, education). Union preferences for different forms of pay (e.g., protecting retirement and health care plans) and their concern with job security affect pay strategy. Unions' interests can differ. In Denver, Colorado, a merit pay plan was developed collaboratively by the Denver Public Schools and the Denver Classroom Teachers Association, the local union affiliate. Teachers approved the agreement by a 59 percent to 41 percent vote, and Denver voters approved a $25 million property tax increase to pay for it. Conversely, many teachers in Springfield, Massachusetts, left for neighboring, higher-paying school districts in part because the district wanted to impose a merit pay plan. Compensation deals with unions can be costly to change. The U.S. auto companies negotiated "The Jobs Bank" program that began in 1984 with the United Auto Workers. Employees who were no longer needed to make cars continued to get paid until they were needed again. Some received up to $100,000 a year, including benefits. Their job: Do nothing but wait for a job to open up. But for a number of people, those jobs never materialized. In various cities around the United States, about 15,000 employees showed up at designated locations (to be paid not to work) at 6 a.m. each day and stayed until 2:30 p.m., with 45 minutes off for lunch. Some volunteered for approved community projects or took classes. Jerry Mellon claims, "They paid me like $400,000 over 6 years to learn how to deal blackjack." Readers may wonder if the Jobs Bank was a compensation strategy that trumped the business strategy. No wonder GM eventually bought its way out of the Bank. No wonder GM recently found it necessary to go through bankruptcy.

DEVELOPING A TOTAL COMPENSATION STRATEGY: FOUR STEPS

Developing a compensation strategy involves four simple steps, shown in Exhibit 2.6. While the steps are simple, executing them is complex. Trial and error, experience, and insight play major roles. Research evidence can also help. Step 1: Assess Total Compensation Implications Step 2: Map a Total Compensation Strategy Steps 3 and 4: Implement and Reassess

SOURCE OF COMPETITIVE ADVANTAGE: THREE TESTS

Developing and implementing a pay strategy that is a source of sustained competitive advantage is easier said than done. Not all compensation decisions are strategic or a source of competitive advantage. Three tests determine whether a pay strategy is a source of advantage: (1) Is it aligned? (2) Does it differentiate? (3) Does it add value?

Different Strategies within the Same Industry

Google, Microsoft, and SAS all compete for software engineers and marketing skills. In its earlier years Microsoft adopted a strategy very similar to Google's, except its employees "put some skin in the game"; that is, they accepted less base pay to join a company whose stock value was increasing exponentially. But when its stock quit performing so spectacularly, Microsoft shifted its strategy to increase base and bonus from the 45th percentile of competitors' pay to the 65th percentile. It still retained its strong emphasis on (still nonperforming) stock-related compensation, but eliminated its long-standing, broad-based stock option plan in favor of stock grants. Its benefits continue to lead the market. More recently, Microsoft, as CNET put it, "took another step toward middle age" by "significantly scaling back its stock awards for employees, replacing that with cash." CNET describes this shift as "implicitly acknowledging that its stock performance isn't enough [any more] to retain top talent." Microsoft has gone from being #8 on the first (1998) list of 100 Best Companies to Work For to being #86 on the 2014 list. However, by 2017 it was back up to #2. SAS Institute, the world's largest privately owned software company, takes a very different approach. It emphasizes its work/life programs over cash compensation and gives only limited bonuses and no stock awards. Like Google, SAS is regularly one of the top companies on the 100 Best Companies to Work For list (e.g., #1 in 2011, #3 in 2012, #2 in 2013, #2 in 2014, #4 in 2015, #8 in 2016, #37 in 2017). SAS, headquartered in Cary, North Carolina, includes free onsite child care centers, subsidized private schools for children of employees, doctors on site for free medical care, plus recreation facilities. Working more than 35 hours per week is discouraged. By removing as many of the frustrations and distractions of day-to-day life as possible, SAS believes people will focus on work when they are at work and won't burn out. SAS feels, for example, that programming code written by someone working a 35-hour week will be better than that written by tired employees. Google so far retains the excitement of a start-up, Microsoft has morphed into "the new Boeing—a solid place to work for a great salary." SAS emphasizes its work/family programs and work/nonwork balance. So, all these examples illustrate the variance in strategic perspectives among companies in different industries (Google, Nucor, Merrill Lynch) and even among companies in the same industry (Google, Microsoft, SAS).

SIMILARITIES AND DIFFERENCES IN STRATEGIES

In Exhibit 2.1 we compare compensation strategies at Google, Nucor, and Merrill Lynch. Google is a popular Internet search engine company. Nucor is a pioneer in recycling steel scrap and other metallics into steel products, including rebar, angles, rounds, channels, flats, sheet, beams, plate, and other products. Merrill Lynch, now part of Bank of America, is a financial services organization that had an eventful several years (following the 2018 Great Financial Crisis) and advises companies and clients worldwide. We will focus primarily on financial advisors ("brokers") at Merrill Lynch. (See Your Turn: Merrill Lynch at the end of this chapter.) All three have been innovators in their industries. Their decisions on the five dimensions of compensation strategy are both similar and different. All three formulate their pay strategies to support their business strategies. All three emphasize outstanding employee performance and commitment. However, there are major differences. Google (now called Alphabet), while in fact one of the largest companies in the world with a market value of over $700 billion, positions itself as still being, at heart, the feisty start-up populated by nerds and math whizzes. It offers employees such generous stock programs that many of them have become millionaires. Its benefits are "way beyond the basics" compared to its competitors. (Yes, there is a free lunch, a gym, a grand piano, bocce courts, a bowling alley, and roller hockey in the parking lot. There is also food: 25 cafés in the company, all free.) Not surprisingly, Google was named the best company to work for by Fortune in 2007, 2008, 2012, 2013, 2014, 2015, 2016, and 2017. Google has traditionally not emphasized cash compensation (base plus bonus) in its communications, but the reality is different. For example, Google was ranked #1 on Glassdoor's list of Top Companies for Compensation & Benefits. According to Glassdoor, the mean salary for a senior software engineer at Google is $163,277 plus an average $37,562 in additional variable pay (e.g., bonuses) for a total of $200,839, compared to the national average of $121,185 plus $9,977, a total of $131,162. A few years ago, Google implemented an across-the-board 10 percent increase in base pay, reportedly based on employee survey results indicating that Google employees "consider salary more important than bonuses or equity." Google also believes strongly in pay for performance. Laszlo Bock, its former Head of People Operations, in his book, Work Rules!, recommends that organizations "Pay unfairly (it's more fair!)." Bock explains that a small percentage of employees create a large percentage of the value and that their pay must recognize their disproportionate contributions. At Nucor Steel, the emphasis is on high productivity, high quality, and low-cost products. Nucor provides an opportunity for those who are willing to work hard to make a lot of money by helping the company be productive and profitable. Consider that in a good year, an hourly worker can make $75,000 or more per year in wages and bonuses combined. That compares to an average annual wage in U.S. manufacturing of about $47,000 (based on U.S. Bureau of Labor Statistics data). In addition, Nucor has had no layoffs, even when sales dropped from $23.7 billion in 2008 to $11.2 billion in 2009. Thus, when Nucor says in its corporate mission statement that it succeeds by "working together" and that all of its customers are important (including employees), its actions show it takes these words seriously. However, some workers at Nucor did experience substantial reductions in pay (primarily in bonus payouts) a few years ago when competition in the steel industry, including from imports, drove steel prices and profits lower. Thus, Nucor's labor costs are flexible downward when necessary, but that flexibility is not achieved through the use of layoffs. (Indeed, this flexibility helps avoid layoffs.) Merrill Lynch pay objectives are straightforward: to attract, motivate, and retain the best talent. Merrill Lynch relies heavily on the human capital of its employees to compete. One of its segments is Global Markets and Investment Banking, an area where a lot of money can be made, but also where a lot of money can be lost, as we saw during the financial crisis late in the last decade. Our focus here is on the Global Wealth Management segment and its key group, financial advisors (brokers). There are about 15,000 advisors at Merrill Lynch. For every $100 million in client assets under management, about $1 million in fees and commissions (referred to as "production") is generated. A financial advisor at Merrill Lynch generating $5 million or more of production would receive a bonus equal to 50% of this amount, or $2,500,000. Advisors with smaller production would receive a smaller percentage. For example, a financial associate with production of $500,000 would receive 40%, or $200,000. Over time, depending on the year (and strategic focus), there have also been separate incentives for team production, adding new clients, and growth in production. Merrill Lynch went through a turbulent period, having been acquired by Bank of America in a deal brokered by the U.S. Treasury Department. However, unlike its former key competitors like Lehman Brothers, which entered bankruptcy, and Bear Stearns, which appears to have lost its identity within J.P. Morgan after being acquired, Merrill Lynch has retained its separate identity and is structured as a wholly owned subsidiary of Bank of America. Its compensation approach for brokers, its key employee group, remains essentially unchanged. The aggressive pay-for-performance approach at Merrill Lynch was traditionally seen as a key factor in generating substantial wealth both for shareholders and for many of its employees over the years. However, that same aggressive pay-for-performance approach at Merrill Lynch (and at its competitors), most notably in the Global Markets and Investment Banking segment, is now seen as having been a key factor in the "meltdown" in the financial industry. A widely held view is that this aggressive approach led to too much risk-taking (e.g., in areas of the business like subprime lending and currency trading) and consequently the downfall of firms in the financial industry. So, the same aggressive approach that was seen as the core of a culture that generated substantial wealth for Merrill Lynch shareholders, and many employees, subsequently was identified as the culprit in the downfall of Merrill Lynch and its peers. What about going forward? Forbes Magazine included an article a few years after the acquisition called "Here's Why Bank of America Loves Merrill Lynch." It reported that Merrill Lynch was producing a disproportionately high share of Bank of America overall net income, which often continues to be the case. For example, in recent results, Merrill Lynch, which accounts for 8.6 percent of Bank of America's employees, produced 15.9 percent of its income. You will have an opportunity to focus further on compensation at Merrill Lynch in the Your Turn section at the end of this chapter. These three companies are in very different businesses, facing different conditions, serving different customers, and employing different talent. So the differences in their pay strategies may not surprise you. Pay strategies can also differ among companies competing for the same talent and similar customers.

Add Value

Organizations continue to look for the return they are getting from their incentives, benefits, and even base pay. Compensation is often a company's largest controllable expense. Because consultants and a few researchers treat different forms of pay as investments, the task is to come up with ways to calculate the return on investments (ROI). But this is a difficult proposition. As one writer put it, "It is easier to count the bottles than describe the wine." Costs are easy to fit into a spreadsheet, but any value created as a result of those costs is difficult to specify, much less measure. Current attempts to do so are described in Chapter 18, Management. Trying to measure an ROI for any compensation strategy implies that people are "human capital," similar to other factors of production. Many people find this view dehumanizing. They argue that viewing pay as an investment with measurable returns diminishes the importance of treating employees fairly. In Chapter 1 we discussed the need to keep all objectives, including efficiency and fairness, in mind at the same time. No doubt about it, of the three tests of strategy—align, differentiate, add value—the last is the most difficult. Are there advantages to an innovative compensation strategy? We do know that in products and services, first movers (innovators) have well-recognized advantages that can offset the risks involved—high margins, market share, and mind share (brand recognition). But we do not know whether such advantages accrue to innovators in total compensation. What, if any, benefits accrued to Microsoft, one of the first to offer very large stock options to all employees, once its competitors did the same thing? What about General Mills, who was among the first to offer some managers a choice of more stock options for smaller base pay? Does a compensation innovator attract more and better people? Induce people to stay and contribute? Are there cost advantages? Studies are needed to find the answers.

Differentiate

Some believe that the only thing that really matters about a strategy is how it is different from everyone else's. If the pay system is relatively simple for any competitor to copy, then how can it possibly be a source of competitive advantage? The answer, according to the advocates of the strategic approach, is in how the pay system is managed. This rhetoric is appealing, but the evidence to support it is slim. The map profiles in Exhibit 2.8 show how Microsoft and SAS differ in their strategies. One uses pay as a strong signal; the other uses pay to support its "work/family balance" HR strategy. Both organizations claim to have organization cultures that value performance, yet their compensation strategies differ. Are they difficult to imitate? Probably, because each strategy is woven into the fabric of the company's overall HR strategy. Copying one or another dimension of a strategy means ripping apart the overall approach and patching in a new one. So, in a sense, the alignment test (weaving the fabric) helps ensure passing the differentiation test. Microsoft's use of stock awards for all employees—often worth considerably more than people's base pay—is difficult for its competitors to copy. SAS's work-family-balance (like Medtronic's total-presence-at-the-workplace strategy) is difficult to copy. It may be relatively easy to copy any individual action a competitor takes (i.e., grant stock options to more employees or offer more choice in their health insurance). But the strategic perspective implies that it is the way programs fit together and fit the overall organization that is hard to copy. Simply copying others by blindly benchmarking best practices amounts to trying to get in and/or stay in the race, not win it. (Of course, being in the race, or achieving competitive parity, may be a major improvement for some organizations.)

Different Strategies within the Same Company

Sometimes different business units within the same corporation will have very different competitive conditions, adopt different business strategies, and thus fit different compensation strategies. The business units at United Technologies include Otis Elevator, Pratt & Whitney aircraft engines, Sikorsky Aircraft, Climate Controls/Security, Aerospace, and Building/Industrial Systems. These businesses face very different competitive conditions. The Korean company SK Holdings has even more variety in its business units. They include a gasoline retailer, a cellular phone manufacturer, and SK Construction. SK has different compensation strategies aligned to each of its very different businesses. A simple "let the market decide our compensation" approach doesn't work internationally either. In many nations, markets do not operate as in the United States or may not even exist. People either do not—or in some cases, cannot—easily change employers. In China, central Asia, and some eastern European countries, markets for labor have emerged only relatively recently. Even in some countries with highly developed economies, such as Germany and France, the labor market is highly regulated. Consequently, there is less movement of people among companies than is common in the United States, Canada, or even Korea and Singapore. The point is that a strategic perspective on compensation is more complex than it first appears.

Steps 3 and 4: Implement and Reassess

Step 3 in Exhibit 2.6 is to implement the strategy through the design and execution of the compensation system. The compensation system translates strategy into practice—and into people's bank accounts. Step 4, Reassess and Realign, closes the loop. This step recognizes that the compensation strategy must change to fit changing conditions. Thus, periodic reassessment is needed to continuously learn, adapt, and improve. The results from using the pay system need to be assessed against the objectives we are trying to achieve.

GUIDANCE FROM THE EVIDENCE

There is consistent research evidence that the following practices do matter to the organization's objectives. - Internal alignment: Both smaller and larger pay differences among jobs inside an organization can affect results. Smaller internal pay differences and larger internal pay differences can both be a "best" practice. Which one depends on the context; that is, the fit with business strategy, other HR practices, the organization culture, and so on. - External competitiveness: Paying higher than the average paid by competitors can affect results. Is higher competitive pay a "best" practice? Again, it depends on the context. - Employee contributions: Performance-based pay can affect results. Are performance incentives a "best" practice? Once more, it depends on the context. Managing compensation: Rather than focusing on only one dimension of the pay strategy (e.g., pay for performance or internal pay differences), all dimensions need to be considered together. - Compensation strategy: Finally, embedding compensation strategy within the broader HR strategy affects results. Compensation does not operate alone; it is part of the overall HR perspective. So, specific pay practices appear to be more beneficial in some contexts than in others. Thus, best practice versus best fit does not appear to be a useful way to frame the question. A more useful question is, What practices pay off best under what conditions? Much of the rest of this book is devoted to exploring this question.

Step 1: Assess Total Compensation Implications

Think about any organization's past, present, and—most vitally—future. What factors in its business environment have contributed to the company's success? Which of these factors are likely to become more (or less) important as the company looks ahead? Exhibit 2.6 classifies the factors as competitive dynamics, culture/values, social and political context, employee/union needs, and other HR systems. Business Strategy and Competitive Dynamics—Understand the Business - This first step includes an understanding of the specific industry in which the organization operates and how the organization plans to compete in that industry. This corresponds with the first two decisions in Exhibit 2.2: What business should we be in, and how do we win in that business? To cope with the turbulent competitive dynamics, focus on what factors in the business environment (i.e., changing customer needs, competitors' actions, changing labor market conditions, changing laws, globalization) are important today. What will be important in the future? What is your company's strategy? How do you compete to win? How should the compensation system support that strategy? Learn to gauge the underlying dynamics in your business (or build relationships with those who can). We have already discussed aligning different compensation strategies with different business strategies using the examples of cost cutter, customer centered, and innovator (Exhibit 2.3). But be cautious: As we have already pointed out, reality is more complex and chaotic. Organizations are innovators and cost cutters and customer centered. All three, and more. The orderly image conveyed in the exhibits does not adequately capture the turbulent competitive dynamics underlying this process. Competitive dynamics can be assessed globally. However, comparing pay among countries is complex. In Chapter 1, we noted differences in hourly labor costs and productivity (output per dollar of wages) among countries. But as we shall see in Chapter 16 on global pay, countries also differ on the average length of the workweek, the average number of paid holidays, the kinds of national health care and retirement programs, and even how pay is determined. Nevertheless, managers must become knowledgeable about competitive conditions both globally and locally.